If We Were in Charge

The Daily Reckoning

Jan. 26, 2011, 10:14 AM

With regard to equity market valuations, other factors equal, as the capital base erodes, so does aggregate corporate profitability. Fewer factories = fewer profits. That said, if there is inflation, then the price level and headline revenues may continue to increase, but real economic profits will nevertheless decline. Even if shrinking capacity results in stable price margins, investors should be wary about buying into an eroding capital stock, which is what we have at present. But if margins are under pressure due to soaring input costs, then the combined impact on corporate profits, over time, could be unusually severe.

No doubt mainstream economists will not see this coming, just as they nearly universally failed to forecast a financial crisis from the mid-2000s. Given the analysis provided above, it should be no surprise that many prominent Austrian economists generally did anticipate a crisis, although they were uncertain on timing, with some predicting a crisis as early as 2004. Going forward, we should now heed their predictions which, unfortunately, are rather grim. And to whatever extent that policymakers are serious about fixing the underlying problems of the US economic malaise, rather than merely treating the symptoms, they, too, should listen.

While it is beyond the scope of this essay to go into much detail, Austrian economists would generally recommend actions such as the following:

Wind down current, inflationary monetary policies and either eliminate the Federal Reserve system or at a minimum place the dollar back onto some sort of explicit, metallic monetary standard to eliminate monetary inflation and restore international confidence in the dollar as a store of value;

Wind down counterproductive government subsidies for consumption, including entitlement programs, thereby rebalancing economic activity from consumption to savings and investment;

Lower (or eliminate entirely) taxes on payrolls, savings and investment. To the extent that taxes are required to finance services considered essential, shift from indirect to direct taxation;

Encourage state and municipal bankruptcy as a way to get public sector costs under control;

Taken together, these actions would stop the erosion of the capital base in its tracks and prevent a further decline in the US standard of living down the road. Yes, they might cause a recession in the near-term, but if that is what it takes to restore sustainable economic growth for the future, we consider that a price worth paying. And no, we are not recommending some strange economic experiment here. The sorts of policies suggested above might be politically unpalatable but they are economically tried and tested

Indeed, the Austrian economic school came into existence as a coherent explanation for the increasingly negative, unforeseen economic consequences of an early lurch toward socialism in Germany and other central European economies in the 19th century. It was two generations later, in the early 20th century, when the Austrian school systematically refuted the tenets of Marxism, an extreme form of interventionism. In the late 1920s, von Mises and other Austrians were ringing alarm bells that the boom was unsustainable and, as such, predicted the 1929 stock market crash and subsequent global financial crisis. As the US lurched toward interventionism in 1930-yes, folks, Hoover was an interventionist notwithstanding FDR's 1932 campaign rhetoric-the Austrians warned that this would prolong the recession for years to come. (We encourage readers to ponder why, given this impressive track record, the Austrian economic school has been generally out of favor for decades. Could it be that policymakers don't generally embrace ideas which imply that their various interventions are not only unnecessary, but outright dangerous to economic health?)

We do not presume to predict what a given stock market, or bond market, or commodity market will do this day or the next. What we do know is that, as prices rise and fall, for their various reasons, investors learn lessons which, once internalized, can change their behavior for years to come. They cannot, by their individual actions, change the world in short order. In aggregate, however, through the entirely voluntary, non-violent act of investing sensibly, rather than falling prey to the deceptions of policymakers, they can force enormous, positive changes on the system over time.

We notice in the mainstream economic press an increasingly fearful, even hostile tone directed toward those, like us, who offer up Austrian-style, generally free-market policy suggestions. This is highly encouraging. Why? Well, consider the following: Earlier this month the US celebrated Dr. Martin Luther King Day, in honor of a man who, through entirely peaceful, non-violent methods, contributed to enormously positive social changes during and after his time. (What on earth does this have to do with Austrian economics? Please bear with us for a moment.)

Dr. King was known to have fashioned his methods, to some extent, on those which had been employed successfully by Dr. Mahatma Gandhi some two decades earlier. And as Dr. Gandhi once said: "First they ignore you; then they ridicule you; then they fight you; then you win." Well, as the economic mainstream is no longer ignoring but rather fighting credible, alternative views, Gandhi's wisdom should give those of an Austrian economic persuasion reason to be optimistic for the future. We need not be heroic, only patient.

[Editor's Note: The above essay is excerpted from The Amphora Report, which is dedicated to providing the defensive investor with practical ideas for protecting wealth and maintaining liquidity in a world in which currencies are no longer reliable stores of value.]

If We Were in Charge originally appeared in the Daily Reckoning. The Daily Reckoning, offers a uniquely refreshing, perspective on the global economy, investing, gold, stocks and today's markets. Its been called "the most entertaining read of the day."